Market Theory of Wage Determination

Classical economists argue that wages—the price of labor—are determined (like all prices) by supply and demand. They call this the market theory of wage determination. When workers sell their labor, the price they can charge is influenced by several factors on the supply side and several factors on the demand side. The most basic of these is the number of workers available (supply) and the number of workers needed (demand). In addition, wage levels are shaped by the skill sets workers bring and employers need, as well as the location of the jobs being offered. When the city recently named by Forbes Magazine as the most miserable city in America (we don't want to make them more miserable by naming them; look it up on the Google) advertises for a city planner, it may have to sweeten the pot to attract good talent.

The interplay between all of these factors will eventually cause wages to settle—that is, the number of workers, the number of jobs, the skills involved, and the location of the jobs will eventually lead workers and employers to reach a series of wage agreements. If employers (demand) cannot find enough workers to meet their needs, they will keep raising their wage offers until more workers are attracted. If workers are in abundance (supply), wages will fall until the surplus labor decides to go elsewhere in search of jobs. When supply and demand meet, the equilibrium wage rate is established.

Long story short: the price of labor is determined in the free market just like every other price, by the intersection of supply and demand.

Why It Matters Today

But what happens if the equilibrium wage rate is less than the minimum wage? What if unemployment is so bad in your town that thousands of people are willing to work for $4 an hour; sure, it's way less than minimum wage but anything is better than nothing, right?

If you play around with your supply and demand curves, you'll see that an artificial wage floor should increase unemployment among low-wage workers. That creates an interesting dilemma for policymakers, of course: the minimum wage helps those who have jobs that would otherwise pay less, of course, and (as you'll see on the next page) also has the effect of lifting wages even for non-minimum-wage workers. But that comes at the cost of increasing joblessness. Once again, as ever, we have a case of tradeoffs and opportunity costs. What do you think: does the minimum wage do more harm than good?

Sometimes, a Song Says it Better: She Works Hard for the Money, by Donna Summer

“It’s a sacrifice working day to day

For little money just tips for pay”

Donna Summer comments on how hard she works for her pay. She
might recommend an advanced degree.